A quarterly magazine of urban affairs, published by the Manhattan Institute, edited by Brian C. Anderson.
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A Tale of Two Paulsons
The free market is dead; long live the free market.
21 November 2008
Last week, Treasury Secretary Henry Paulson announced, mercifully, that he would kill an ill-considered plan to purchase mortgage-backed securities and other value-losing assets from the financial institutions that hold them. Right on schedule, John Paulson, a private hedge-fund manager, has reportedly told his investors that he would start buying up some of these assets.
The two events, unlike the two Paulsons, are related. If the government had started to buy up mortgage-related assets under its now-abandoned plan, private investors would have had to consider how massive government purchases, unrelated to real market prices, would distort those prices. Further, the same investors would need to worry that a few months or years from now, the government would begin selling such securities en masse, artificially depressing prices with its sales after artificially inflating them with its purchases. Now that the governmentHankhas removed a big chunk of that political risk, the private sectorJohnis doing what its supposed to do, assessing the securities worth rather than trying to predict the governments future buying and selling habits.
Early buyers like Johns fund will pay particularly low prices for these securities, and sellers will have little choice in the matter. Now that they know Hank wont be coming to the rescue, financial institutions will once again start selling their value-hemorrhaging, mortgage-related securities. Theyd already started to do so in the spring and summer; Merrill Lynch, for example, let go some securities for 22 percent of face value to a private-equity buyer.
As funds like Johns start buying mortgage-backed security assets and the like at rock-bottom prices, theyll help the market discover the securities true value over time, and help push that value up. In order to see a profit, theyll eventually have to sell their securities for higher prices than they paid for them. Its likely, though, that this wont just be a game of waiting, like buying a stock at what seems like a low price and hoping it goes up. Instead, these buyers likely will have to use their clout as big investors to make changes in the unaffordable, unsustainable mortgages that the securities in which theyre investing hold. Such changes in the underlying mortgages may be the only way to prevent more mortgage defaults and the big cash losses in the securities that would follow. Markets are already predicting big losses, depressing the price of the securities. Credible changes to the securities to prevent such an outcome would raise the securities prices over time.
Restructuring the mortgages contained within the complex securitiesincluding forgiving mortgage debt for some homeownerswould allow at least some of the five to seven million households that could face foreclosure in the next half-decade or so to avoid that fate. A homeowner who cant make 6.5 percent interest payments annually on a $300,000 mortgage on a house in Las Vegas, for example, might be able to make the much smaller payments that would apply to a $150,000 mortgagewhich could just be the current value of the house, anyway. When a firm like Johns buys such securities at what seem like low prices, it has lots of room to make a profit, given the drastic debt reductions in the value of the mortgages. If John purchases securities at, say, 30 cents on the dollar, for instance, even reductions of 50 percent or more in the underlying mortgage debt could prove profitable for his fund.
Of course, its not that simple. First, investors like John cant just change the mortgages themselves; only the servicer of the mortgage-backed securities, who handles administrative matters on investors behalf, can do that. However, the good news is that in many cases, the servicer doesnt require investors permission to modify the mortgages inside the trust. As Mary Coffin, executive vice president at loan servicing and post-closing at Wells Fargo Home Mortgage, told investors at a conference last week, servicers often enjoy vast discretion to modify mortgages without explicit investor permission. And as Paul Koches, executive vice president of the sixth-largest servicer of subprime mortgages, Ocwen Financial, told the Wall Street Journal recently, his firm has reduced principal this year on 10,844 of the mortgages it services. Still, servicers often want at least some guidance from investors on what to do. As more and more investors like John Paulson buy in at low prices, theyll push for further mortgage restructurings, encouraging servicers to act more boldly.
Unfortunately, the documents governing some mortgage-backed securities prohibit any mortgage modifications without the unanimous permission of investors in the securities. In these cases, its always going to be a tough slog to get a group of people to agree on anything. But it may be easier now. The investors most likely to object to mortgage restructurings are those who invested in the safest pieces of the mortgage-backed securitiesthat is, the securities that were structured so that their holders dont take serious cash losses until a substantial portion of the underlying mortgages are in default. But after Hanks announcement that the government wont buy up these securities, the market prices of even these safest subprime mortgage securities plummeted to a new historic low, an indication that the market thinks significant cash losses on these senior securities are at least conceivable. Such low prices may be telling the holders of the senior securities that it would be better for them to agree to a certain but smaller loss now than to wait for an uncertain but potentially large loss later.
Despite fresh stock-market lows this week, both Paulsons announcements should give observers a glimmer of hope. Free-market actors like John Paulsons fund still exist, though its hard to find them amidst the wholesale socialization of the bigger actors in the financial sector. These free-market actors have a vital role in helping to navigate us out of what is still an unimaginably complex mess. But we need to have the fortitude to let them do it.
Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst.